Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and serves on the Committee on Capital Markets Regulation. He is also a faculty research fellow at the National Bureau of Economic Research, a research fellow at… read more

Democracy’s Burning Ships

CHICAGO – Since the late 1970’s, the academic diffusion of game theory has led macroeconomists to emphasize the importance of “commitment,” a strategy that aims to enhance long-term economic outcomes by restricting policymakers’ discretion. The idea seems counterintuitive: How can less produce more?

While not historically accurate, one of the best examples of a strategic commitment is provided by the legend of Hernán Cortés, according to which, in his quest to conquer Mexico, he decided to burn the ships that had brought his expedition from Spain. At first, this might seem like a crazy move: Why intentionally destroy the only possible way out in case of defeat? Cortes allegedly did it to motivate his troops. With no escape route, soldiers were highly motivated to win. Alexander the Great is said to have done something similar when conquering Persia.

To produce its benefit, a commitment strategy should be credible – that is, it cannot be reversed quickly. In this sense, Cortés’s strategy was perfect: in case of defeat, the Spanish would have no time to rebuild the burned ships. To work properly, a commitment strategy should also be costly in case of failure: had Cortés lost, no Spanish soldier would have escaped alive. It is precisely this cost that helped motivate his soldiers.

The problem is that we are bound to hear about only the successful historical examples of such a strategy. Had Cortés’s strategy failed, he would have gone down in history – if he was remembered at all – as an arrogant fool who thought that he could defeat a great empire.

One of the earliest applications of this strategy to economic policy is in the design of central banks. Monetary policymakers, the argument goes, should be independent from the political system, because, when elections near, politicians will likely pressure them to “buy” temporarily higher employment at the cost of permanently higher inflation. To prevent this inefficient trade off, governments should tie central bankers’ hands by insulating them from political influence.

Many macroeconomists attribute the sustained decline in inflation since the early 1980’s to the widespread use of this strategy. And, encouraged by its success, policymakers started applying it elsewhere. Financial liberalization was sold as a commitment to follow market-friendly policies. If a future government deviated from the policy, capital flight would bring it to its knees.

The same applies to extensive government borrowing from abroad, to currency boards, even to currency unions. The creation of the euro is nothing but an extreme form of commitment: European governments tried to lash themselves to the German mast of fiscal discipline.

The diffusion of these mechanisms raises the issue of democracy. When Cortés allegedly burned the Spanish ships, he did not take a poll. Had he done so, he might have won (the strategy was clever), but it was not a foregone conclusion.

But even if the commitment strategy produced beneficial incentives, it might not have been worth the risk. Perhaps Cortés, blinded by his dreams of glory, was ready to sacrifice his troops even when the odds of victory were too slim.

Nowadays, fortunately, democratically elected governments make these decisions, which thus should reflect the people’s will. Yet, given their nature, these decisions deserve special scrutiny. After all, they are – by design – irreversible decisions that tie the hands of future governments, which makes them tantamount to constitutional norms. As such, they should not be subject to the same approval process as normal legislation.

This problem is particularly severe when the up-front action that seals the commitment has short-term benefits that are more attractive than burning the ship. When a government starts to borrow abroad or chooses to enter a currency union, these benefits take the form of reduced interest rates. Thus, the immediate benefits become more politically salient than potential future costs. By using this strategy, a Machiavellian government can induce a reluctant electorate to accept a policy that is contrary to its will.

Many people would say that this is exactly the point. For southern European countries, joining the euro was – explicitly or implicitly – a way to force their citizens to accept a degree of fiscal discipline that they were incapable of adopting on their own. But was this a democratic decision, or one that an “enlightened” elite forced upon its unwitting citizens?

I fear that the latter is true – hence the growing resentment against the European Union. To add insult to injury, current European leaders do not “own” their past decisions. They do not admit that they or their predecessors are the ones who burned the ships. They blame Europe. The result is that the euro, sold as a way to integrate Europe further, is tearing it apart.

Comments

The EU is more like the chastity belts alledgedly used during the Crusades where the blacksmiths kept a copy of the key. With only a monetary union, you ended up with the benefits of lower interest rates, which politicians used to their personal gain, along with continued fiscal profligacy and cheating.

The appropriate analytic framework isn't classic game theory, but Mancur Olson's "Logic of Collective Action" and particularly "Rise and Decline of Nations." They didn't burn the boats, elites merely hid them, and in the case of Greece swapped them with Goldman Sachs.

The problem wasn't "commitment," it was "cheating" and now the "cheaters" are complaining about the results.

In democracies without fiscal discipline, politicians will always put their short-term interests in terms of handing out "goodies" to favored interest groups above long-term financial health. The only difference between the various factions and parties -right, left and center - is to whom the "goodies" are distributed. Monetary policies, by aiding and abetting the fiscal authorities, or in the case of the EU giving them the keys to the chastity belt, facilitated this process. Colloquially, this is known as having your cake and eating it too.

More generally, everybody - both governments and consumers - ate way too much cake (ie: debt) for decades, while the technocrats couldn't figure out why everyone kept getting fatter.

The "people's will" is by definition fluid and I personally can't remember anyone complaining about how much cake they were getting prior to the crisis.

As the social contract theorists among others have pointed out, government is by definition a precommitment to certain rules and norms that tie future generations hands. Any legistlative decision is "path dependent" and constrains the future will of the people. The fiscal decisions, prior to and after the Maastritch Treaty, determined the current fiscal path and any attemtpt to change them would be against the will of the people who are benefitting from the government goodies," which is everyone since everyone has their fingers in the pie. Any solutions to the current problems would, by definition, be against the will of the people, because it would imply taking away their "goodies" and imposing long-term fiscal discipline.

Economics is about the allocation of inherently scarce resources.Without a precommitment to respect the laws of economics, you end up with the 5th anniversary of the current financial crisis with no end in sight. We didn't burn the boats, we ate them. Read more

Very interesting argument, though, it is left to a ...contradictory state! For example, it does not discuss the case of a pure shift in peoples' will, rather than its manipulation by a "Machiavellian" government, and how could these cases be separated in an objective way...

Nevertheless, it is very interesting to observe the way that submission to budget discipline was brought about eurozone members, that is their currency, in light of the famous quote by Mayer Rothchild:"Give me control of a nation's money. and I care not who makes it's laws."

It is also interesting to realize the nature of monetarism and all currencies in the era of money and "fractional reserve" banking, that legally only supports trade and the payment of taxes, with money and no other means (e.g. no direct exchange of goods), and gives control over money creation and the remote exchange of money to private banks!

This sheds new light to the argument in this article, and dismounts the contradiction mentioned above. Because, regardless if peoples chose it or not, it is exposed very clearly today that there is no choice left to the people, when an establishment of politicians implement such institutions, and are heavily influenced, manipulated, and more-or-less controlled by the bankers' establishment to keep them in place. The basic malfunction in this situation is that, in order to influence and modify the monetary and currency system, we need to change the whole system of government! Even worse in the case of the eurozone, where the "system of government" is very loosely linked to the peoples... These two institutions, monetary authorities and government, probably need to be completely separated and their directing bodies elected directly by the people. Read more

Well, ideally, the Taino would have executed Columbus and all his men. The same for Cortes and Pissarro, and the Puritans and Pilgrims. Capitalism may have, then, actually been short circuited and an abysmally violent, poor, and sickly Europe would have remained contained for at least awhile longer. Alas, the Spanish were welcomed, at least until the Taino realized that they were to be enslaved; that the Spanish would use armored bull mastiffs to hunt down any resisting "Indian" and rip him to shreds. European diseases did the rest, reducing populations by as much as 90% untold millions just in the Caribbean.

Why all this? For gold (capital) with enough Christian dross to give it some superficiality of "transcendance."

To use it now as some sort of lesson for the nature of capitalism--when real capitalism originates in real genocide and slavery--seems, well, tacky. Then again, capitalism and Christianity has never lacked for vicious audacity. Read more

Cortege’s order to arrive in Mexico that all but one of his ships be burnt and destroyed is one classic example of strategic commitment, which not only made the decision intractable and irreversible but also it put off the enemies against such a determined opponent. Luigi brings a very classic argument in the context of decisions that democratically elected governments make that are similar to Cortege’s strategic commitment, but have to contend with the pros and cons for the future.

I perfectly like the example of the Euro that Luigi is pointing but we should see this strategic commitment against two alternatives, one which is a substitute for the Euro (a break up) and the other a strategic compliment (fiscal compact). It would be worthwhile to look at the Nash equilibrium.

In a democratic set-up the biggest issue is timing as incumbents and opposition have only a limited time period to show results, while most of the decisions they take have long term impacts and unintended consequences. This is a remiss that democracy has very little solution to offer and here a longer tenure that China offers to its leaders has a better ground for success, although not a very acceptable denouement for the cause of democracy though.

This is a very complex article, there are a lot of things that could be argued about.For example we could argue about whether there is any true democracy left in "free and democratic" western societies with the media influenced elections and powerful lobby controlled politicians. We can witness live how much and what kind of a choice Americans have for right now for example.But the even greater question is if local, regional or even national freedom and democracy makes sense today.What we learn through the global crisis each day is how much the whole world is interconnected and interdependent.In truth most of the truly important decisions influencing our daily lives are already made at supra-national levels by international interest groups networking all over the globe.Decisions made locally, by subjective, self calculations, ignoring the reality and needs of the total system before making decisions, actually harm the whole system.In a fully global, integral world only a fully functional, supra national, democratic and mutual decision making and action can succeed.In Europe the countries involved in the Eurozone are standing in front of a historical decision that can provide a template for the rest of the world.If they can establish a fully integrated, federal European structure, that can take into consideration all the members, together with their relative strengths and weaknesses and create a system that balances the differences out and channelling the 100% positive contribution of each member country the most optimal way, like cells and organs of a single body, then they could build a structure that is highly superior to anything humanity has built so far.Of course for that each member needs to move beyond their self benefit and consider the whole as priority.And such a system can only work if it is not forced, if people join it through positive motivation, fully understanding that it is in their best interest to sustain the well being of the whole since the prosperity and health of the individual is directly dependent on the prosperity and health of the whole.Thus first of all present leaders need to provide transparent and factual information to the people explaining to all of them the benefits of adapting to today's global reality. Read more

Robert Skidelsky
on why the right economic policies cannot work without the right public expectations.

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